Explaining Bank Overhaul ProposalsCongress has taken up legislation that would prevent big companies from endangering the entire economy when they reach the brink of failure. They would be required to have more capital in reserve and wind down operations in an orderly fashion in the event of a bankruptcy. Would these rules prevent a crisis like the current one?

Congress has taken up legislation that would prevent big companies from endangering the entire economy when they reach the brink of failure. They would be required to have more capital in reserve and wind down operations in an orderly fashion in the event of a bankruptcy. Would these rules prevent a crisis like the current one?

ROBERT SIEGEL, host:

The regulatory overhaul proposals are complicated and confusing. We wanted to understand how the rules would actually work if we faced something like last year's collapse of Lehman Brothers or the near collapse of AIG. Would the new proposals prevent a crisis like the one we've just experienced? So, we turn to Adam Davidson of NPR's Planet Money to help us figure out what might happen. Hi, Adam.

ADAM DAVIDSON: Hey, Robert.

SIEGEL: Well, we just heard Treasury Secretary Geithner refer to facilitating the orderly demise of failing companies. Of course, the demise of firms at the start of the financial crisis was anything but ordinary. So, first question, explain the problem. Why was the government unhappy with how they were able to respond to the crisis?

DAVIDSON: So, we have a long-standing tradition in our legal system of bankruptcy, but - where if a company fails, that's what you do. But bankruptcy takes years and years and years and this was a crisis unfolding in hours and nobody felt like there was years to wait and see what happens with Lehman Brothers or AIG. So, we've known about this for a long time that banks are special institutions, that they have real time, immediate involvement in lots and lots of companies. So, we created the FDIC, you know, after the Great Depression, which comes in and rescues - well, it takes over a bank. It rescues its day-to-day operations, but gets rid of its management and sells it usually very quickly to someone else.

But the problem is, if you think of Lehman Brothers, AIG, Citibank, Bank of America, this is not one company, one bank. These are all massive conglomerates with hundreds of interlocking companies, some of them are banks, some are insurance companies, some are travel agencies or airplane leasing companies or who knows what. And the existing FDIC procedure just doesn't work for them. So, they were stuck in this kind of Goldilocks thing. They only could totally save them or totally let them fail.

SIEGEL: Okay, let's run the movie back, then, to last year and assume that Timothy Geithner's proposals are in place. Lehman Brothers faces eminent collapse, what happens?

DAVIDSON: So, what they say, first of all, is hopefully the regulators have known better, had more advanced notice, but it's not entirely clear. I mean, they are saying there will now be a committee of regulators and we know how committees are always very, very effective. The idea, though, is if it comes to that day and knock on the door, Lehman Brothers is about to go under, that the government does not have to face this Hobbesian choice of either we kill you or we completely save you.

The government now has a tool if this law passes. They can come and fire all the managers, make the shareholders the owners of the company, lose their money, the bond holders, the investors, the debt holders lose their money. But the government comes in and runs the company long enough to slowly sell off the assets.

SIEGEL: Runs the company, sells off the assets and also puts government money in as the government did with AIG or Bank of America or Citibank?

DAVIDSON: Yes. Under this, the Geithner proposal, the taxpayer is still on the hook. We still will have to pay to rescue these companies, but with an important difference, he says. The important difference being that the government will not put any taxpayer money in until the management and the ownership has already suffered the consequences of the collapse. So, we will not be bailing out the actual people who caused the trouble. We'll just be putting money in to keep the bank functioning, so the overall system is stable after the people who caused the trouble have lost.

SIEGEL: Adam, obviously there are going to be more debates on this and we can expect fights about the details of this plan. What do you think the regulation really needs to include to be effective?

DAVIDSON: I think it's something very simple. When I talked to economists, it turns out it's something very simple. It's a feeling of fear. We want the managers of banks, the investors in banks to feel truly in their gut that if this bank gets in trouble, they will lose their money, lose their jobs. They will suffer the consequences. And that is what any legislation needs to provide. If they don't feel that, then they're going to make risky and bad decisions, and we'll probably be back in a financial crisis.

SIEGEL: It needs to say to the bankers, your bank may be too big to fail, but you aren't.

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